March 28 2016

Washington, DC (March 28, 2016) – The IAA is opposing overall portfolio limitations based on gross notional exposure to derivatives in the SEC’s proposed new rule that would govern the use of derivatives by registered funds.

In a comment letter submitted today, the IAA says it supports many of the rule proposal’s goals, but objects to the portfolio limitations as inappropriate. The IAA’s letter also offers a number of other recommendations that would be consistent with the SEC’s goals while making compliance less burdensome for advisers that manage funds. More than 40 percent of the IAA’s approximately 600 member investment advisory firms manage at least one registered investment company or business development company.

The derivatives proposal is the third in a series of rulemakings designed to enhance the SEC’s risk monitoring and regulatory safeguards for funds and the asset management industry. The proposal would, for the first time, condition compliance with Section 18 of the Investment Company Act on the cumulative exposure of all of a fund’s derivatives transactions, financial commitments and indebtedness. The SEC proposed a basic cap of 150 percent, with an exception that would allow up to 300 percent exposure if the fund met an additional test. This represents a significant change in the SEC’s approach to regulating funds’ use of derivatives and would supersede decades of guidance. The use of caps would also, by the SEC’s own admission, cause some currently operating funds to cease operating as registered investment companies.

“It is not appropriate for the SEC to retroactively determine that a particular investment should no longer be available—especially after the funds were created based on an adviser’s good faith understanding of decades-old Commission and staff positions,” said IAA President & CEO Karen Barr. “Investors may have invested in these funds to diversify their portfolios, pursue returns uncorrelated with the broader securities markets, or in the case of market volatility, to protect their retirement or other savings and investments.”

In its comment letter on the derivatives rule proposal submitted today, the IAA notes that while it is supportive of many of the proposal’s goals, the caps are unnecessary. It argued that other elements of the proposed rule, such as asset segregation requirements, are sufficient to constrain leverage and protect investors. The IAA also pointed out that gross notional exposure from derivatives transactions is a measure of volume (i.e., how many contracts are put in place) rather than risk, and that the proposed caps do not take into account factors that may result in lower economic exposure, such as netting or the posting of collateral. And it said that the limits would constrain advisers’ ability to employ certain types of risk-mitigation strategies that are beneficial to investors, reducing investor choice and introducing significant uncertainty into advisers’ business planning.

The IAA’s additional recommendations include::

The definition of “qualifying coverage assets” should include liquid assets other than cash and cash equivalents. The Commission should reconsider limiting qualifying coverage assets to cash and cash equivalents, recognizing that other holdings can be sufficiently liquid to ensure that assets are available for a fund to meet its obligations under a derivatives transaction, even in stressed conditions. In this regard, the Commission might consider applying “haircuts” to qualifying coverage assets other than cash and cash equivalents, similar to those that have been developed with respect to various forms of collateral.

The Commission should more appropriately tailor the requirement for a full-blown derivatives risk management program. While the IAA supports the basic concept in the Proposal, the implementation of a derivatives risk management program and the appointment of a derivatives risk manager will be a substantial compliance undertaking, particularly for smaller fund advisers. The Commission should consider ways to ensure that this burden falls only on those funds with greatest risk to investors from the use of derivatives.

The oversight function of a derivatives risk manager should be able to be fulfilled by either an individual or a committee. Firms should not have to designate one individual to be a derivatives risk manager, where the desired oversight function could be more successfully implemented in a different way, such as through a committee.

The Commission should clarify the definition of “derivatives.” The IAA strongly supports the proposed definition of “derivatives transaction,” but recommend that it be clarified slightly to exclude variation margin under the CFTC rules for margin for uncleared swaps.

The implementation period should be reasonable. The Proposal is necessarily complex, and has the potential to significantly change the nature of compliance with Section 18 under the Investment Company Act. Funds and their advisers will need significant time to understand the final rule, develop the necessary policies and procedures, hire and train personnel, and make appropriate portfolio management systems changes.

The Investment Adviser Association (IAA) is the leading trade association representing the interests of SEC-registered investment adviser firms. The IAA’s more than 600 member firms collectively manage assets in excess of $16 trillion for a wide variety of institutional and individual investors. In addition to serving as the voice of the advisory profession on Capitol Hill and before the SEC, DOL, CFTC and other U.S. and international regulators, the IAA provides extensive compliance and educational services to its membership. For more information, visit www.investmentadviser.org or follow us on LinkedIn and Twitter.